Why it is so hard for the Bank of Canada to crush inflation

Those who think central bankers are powerful and manipulative might ask themselves why people like senior deputy governor Carolyn Rogers don't just snap their fingers and make inflation go away.

The Bank of Canada officials have declared they will be "resolute" in crushing inflation, squeezing it down to the bank's two per cent target range. But that process may be long and painful as rates keep rising.

Even as Rogers warned on Thursday that Canada faces an "expectations spiral," trying to change the direction of inflation is akin to turning the Titanic after you've spotted an iceberg through the fog.

Not that the Canadian economy is anywhere near sinking. Instead, the problem laid out by Rogers is one of an economy that is simply too strong.

"Demand continues to outstrip supply in many parts of the Canadian economy and short-term inflation expectations of Canadians remains high," said Rogers to Calgary Economic Development, a privately and publicly funded agency.

The solution, said Rogers, was to use a sharp rise in interest rates to crush demand, offering supply a chance to catch up.

As the European Central Bank also announced Thursday, the plan is to do what they call "front loading," several large hikes in interest rates in a row quickly to shock the market. It's an attempt to "avoid the need for even higher rates down the road and the more pronounced slowing of the economy that would go with it," said Rogers.

Despite the risk the central bank could "overshoot," raising interest rates too high and sending the economy into a deep recession, the Bank of Canada insists there is still a chance the country could see a soft landing.

Fiscal spending such as European consumer energy subsidies or Canada's social assistance funding push in the opposite direction of where the central bank hopes to go. And rate hikes themselves can make things more expensive.

Global inflation could increase the cost of Canadian imports, although a rising loonie could act as a pad against those inflationary effects. And there is no guarantee there may not be more supply shocks ahead, including for energy, said Rogers.

Another problem central banks always face is that the interest rate cuts or increases they make now may not work their way through the economy for years. Rogers said the same thing is likely to happen this time.

In that way, front loading could give central bankers a chance to read the indicators as they come in, such as GDP, job numbers and other data, and use smaller rate hikes once they see how the economy is reacting — helping to avoid an overshoot.

Consumer spending and wage demands are places where it is relatively easy to see how there is a lag time between rate rises and slower demand.

As others have mentioned in the past, a buildup of savings by those who could afford to save during the pandemic means retail spending will not necessarily respond immediately to higher interest rates. Rogers said the central bank continues to monitor those savings, and they are far from exhausted.